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How a medical device tax will affect the industry

The medical device industry faces a $20 billion tax over ten years to offset the costs of health care reform. Sen. Amy Klobuchar has lobbied against the tax, as two medical device manufacturers -- 3M and Medtronic -- are based in Minnesota.

On Monday, Jan David Wald, a senior medical tech analyst with the Nobel Financial Group, spoke with MPR's Tom Crann about how the tax will affect the medical device industry.

Q: Tell us about the rationale behind the proposal to tax medical device companies.

A: If you go back to the beginning of health care reform, and that means last January, President Obama really did try to sit down with all the different constituencies and come up with a plan as to how they might contribute to the new health care policy. And this is really something that's happened because of that.

I think the med tech companies at the beginning said, "Wait a minute. We're really not going to participate, and it's because you're going to go after some of our customers, like the health insurance companies."

But in the middle of the road, in the middle of the attempt to change health care, the companies were taxed. And I think it was because the government needed to be revenue neutral in terms of what they were doing with health care.

Q: Sen. Amy Klobuchar fought against the tax. How big a hit is $20 billion over ten years for the med tech industry?

A: I think the impact on the companies kind of differs. I think the larger companies can withstand the tax better than the smaller companies. Although the tax is like an excise tax, so it's based on sales, but it's going to be two, three percent of revenue at [the very most], but the impact is going to be down the road. It's going to be on what these companies can do or can't do because of the costs that they now have to incur.

Q: How will it affect them? What won't they be able to do as a result of this tax?

A: Well, my reading, and I've recently talked to a number of the companies is that they're getting squeezed on the top line by this excise tax. And they're getting squeezed on the bottom line in a sense, because there are more requirements they have to meet to get devices approved and more after-market studies that they have to do in order to keep their devices marketable.

And from that perspective, there's less [income] that will allow them to do certain things. They're not going to go after sales. They can go after their administrative costs to some degree, which they already have. I think what really could be affected and could be a problem over the long term is research and development.

Q: Do you think companies will pass on the cost of the tax to consumers and health insurance companies by increasing the costs of the devices?

A: I think the companies will try to do that, but from [speaking with them], I don't believe they think they have much pricing power. So from that perspective, I don't think they can pass the prices on.

I think one thing to consider is that this year the policy discussions have been all about coverage. Next year and thereafter, it's probably going to be about cost and cost containment.

Q: How profitable is the medical device industry?

A: It's been a very profitable sector. You're looking at gross margins for a lot of the companies in the 70s, although the range is probably 55 to 75 [percent]. You're looking at operating margins in the 20s.

So it's a very good business, but they've re-invested a lot of that money in R & D. And it costs a tremendous amount of money to bring a product to market because of all the government requirements that are imposed on the companies. So even though they're highly profitable, if you look at where their expenses are, it really comes down to R & D and those kinds of costs.

If you look at the R & D that most of these companies spend, it's around 11 to 13 percent. That's significantly more than a lot of other companies in a lot of other industries.

Q: Is it because of their high level of profit that they were a target to help get this done? Is there a sense that the tax might hurt but it won't kill them?

A: All the constituencies have given something up. The pharmaceuticals have. The health insurance companies have, although I would consider the health insurance companies to be the winners in this round of policy making. So, all of the constituencies have given something up. I don't think the device companies have been singled out. They just have to contribute.

Q: In the end, how do you think the medical device industry will react to the tax?

A: I think they have to adjust to the new environment. I do believe they're not going to have much pricing power. I do believe their costs are going to go up in order to bring products to market. So they're going to have to make adjustments. And that adjustment, I think, is going to be in terms of people and projects.

Q: Laying off staff?

A: Laying off staff. I think projects will either be discontinued or elongated, and I think the bottom line for the industry is that innovation could be affected. And yet innovation has been one of the drivers behind health care for a number of years.

Q: The question of innovation in this industry is also a question of competition as well, right? Would the tax slow down the development of new products?

A: I believe it would.

Q: Minnesota is one of the centers in the country for medical technology. Are there other parts of the world that the industry can point to and say, "Well, if conditions aren't favorable here, if this is going to hurt us here, we'll just take our business elsewhere?"

A: I think if you look at what the companies are doing, they are beginning to look for less expensive places to do manufacturing. To date, they've looked at R & D and design as being principally done in Minnesota. And I used to live in Minnesota and actually worked for one of the medical device companies. So I think they've been able to, and have by choice, stayed in the Minnesota area for that kind of work.

I think in the future, though, they might look to outsource that. Or maybe even worse for the whole industry and health care in general is they'll reduce it without trying to move it somewhere else.